Streetwise Professor

October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

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  1. How many CDS contracts were written on Glencore debt? How many times was that CDS re-hypothicated? These are valid questions for any large buisiness, and the fact that we still do not have an OTC clearing house for these contracts, combined with some particularly awful non-limitation of the number of times an asset can be re-hypothicated (in the city of London) makes it questionable to be able to say Glencore (or any large multi-national firm) isn’t the next Lehman. Doesn’t mean it is either, but the financial system isn’t much improved in terms of stability, in fact in may be worse than 2008.

    Comment by john — October 6, 2015 @ 6:17 pm

  2. @John. WRT CDS, Lehman wasn’t the next Lehman. The amount outstanding on Lehman had to dwarf what is outstanding on Glencore. People were afraid of the scenario you paint. It didn’t come to pass, even though Lehman debt went for (if memory serves) for 8 pct of principal amount at the ISDA auction (i.e., the recovery rate was 8 pct and the CDS paid off 92 cents on the dollar). The net amounts owed turned out to be relatively small. It was a non-event.

    CDS can’t be rehypothecated: collateral can be. What matters is net positions. A lot of trade is between dealer banks who buy and sell and end up nearly flat. There were about $400 billion in CDS outstanding on Lehman, but when everything was netted out, there was only about $8 billion left, and everything worked smoothly. And that happened when the financial markets were still in a very shaky situation. (The Fannie & Freddie auctions were much messier, but still the system worked through it.)

    Net notional on Glencore is certainly smaller than Lehman’s was, and the recovery rate would almost certainly be larger. Don’t let this keep you up nights either.

    The ProfessorComment by The Professor — October 6, 2015 @ 7:09 pm

  3. CNBC needs a story. Regulators need fear to assert and grab more power. Hillary wants a transaction tax, but only on HFT.

    Comment by Jeffrey Carter (@pointsnfigures) — October 8, 2015 @ 6:03 am

  4. Deutche Bank is more the worry- sudden capital raises, abrupt CEO departures and huge losses when German economy is humming along. And they are much bigger than Lehman

    Comment by Cypriot — October 8, 2015 @ 7:47 am

  5. @prof Pros talks logistics:

    Lehman Brothers gross was 3.3 B$ notional in september 2008.

    On CDS.
    Glencore gross notional is 22.94 B$
    Deutsche bank 27.7 B$

    Let’s hope that no one was silly enough to buy protection on Glencore from… Deutche bank, cause that’d be one hell of a Wrong-Way risk (sic).<

    Comment by simon jacques — October 23, 2015 @ 10:55 pm

  6. Do you trust the financial statements and balance sheets picture of Trafigura, Glencore, Mercuria, Noble Group…

    1-Issues arise: how they mark to market forward contracts ?
    2-Securitization of receivables and trade finance, enable them to have better financial ratios than a bank. (means another party insert_____bank takes the heat)

    It is questionable how much debt Glencore and Trafigura really have once you make adjustments from what I said above.

    3-Financial performance( highly leveraged like a hedge funds, less than 6% of return of capital for Glencore, sales growing at 8.80% CARG but negative FCFs.

    Comment by simon jacques — October 23, 2015 @ 11:13 pm

  7. @john Lehman Brothers execs (like swiss traders today) defended their Books until the last second.
    That was the thinking: “the market is wrong, not us the bank” and have asked the U.S Treasury to relax GAAP accounting rules (mark-to-market) to allow them to be right.

    The biggest enemy of a company like Glencore International AG is its trader because traders have a propensity to defend their books and to authorise their losses. Former traders have become bad management execs and Investment banks have lured them into bad deals that they had not to enter, otherwise Glencore was the finest transportation and marketing operation anywhere in the world (from 93′ to 2011).

    Comment by simon jacques — October 24, 2015 @ 12:12 am

  8. @simon-You are off by only a factor of about 23 wrt to Lehman gross notional. It was $72 billion at the time of its bankruptcy. That netted down to $5.5 billion, and as I noted, settlement of its CDS was a non-event even though the payoff on the CDS was 92 percent of notional.

    Not even close.

    Deutsche Bank is a much bigger concern than Glencore. DB is a monstrosity. It makes Citi look simple and well-managed.

    The ProfessorComment by The Professor — October 24, 2015 @ 2:39 pm

  9. Dear Streetprof. I believe in your 72B$.

    With the Gross Notional on CDS, it is clear that this figure closely tracks the actual number of trades (Volume) occurring in an issuer, and by the time of a bankruptcy this number can go 20X- 50X at the end of a day.

    Lehman Brothers has filled for Chapter 11 bankruptcy protection on September 15, 2008.
    By October 31 2008, Net was 5.567B$ and Gross Notional was 3.903B$ and surprisingly NET was > than Gross.

    For “Hedged”commodity traders or “hedged” banks NET can be > than Gross, once the chain of bilateral netting breaks.

    “that netted down to 5.5B$”, “the payoff on the CDS was 92 percent of notional…” It depends on the settlement, CDS holder were offered 92cent on the dollar now but also note that Lehman B CDS was still traded for at least 3-mths after Sept-15-2008 (during restructuring).

    For Glencore, they have 3 CDS
    Glencore Canada Corporation
    Xstrata Limited
    Glencore International AG
    The total gross notional figure is 29.38 B$, 2.7B$ netted.

    The most interesting part is not the CDS, it is the commodity derivatives book gross notional +200B$ sales (the most lucrative part for a counterparty like GS).

    For Glencore, BofA talks about a gross notional of gross +100B$ that banks and counterparties carry netted as required by U.S Gaap.

    Can OTC derivatives, structured products, non plain-vanilla really be netted ?

    My experience say no, extremely difficult but finance books (PRIMA)and the bank lobby advocate yes for practicality and because Netting allow “Hedged” banks and “Hedged” Commodity Traders to report lower exposures than the full risk they face.

    “Deutsche Bank is a much bigger concern than Glencore. DB is a monstrosity. It makes Citi look simple and well-managed.”

    -Glencore is relatively small, is an undiversified leverage hedge fund on the top of a copper warehouse and has a high risk concentration for banks.

    -For Banks, I see difficult to compare Citi and DB, the former reports on U.S GAAP the other uses International Financial Reporting Standards (IFRS) but both devotes resources, models to prove their solvency.

    It is because you let the markets unregulated that you create these montrosities in the markets.
    We also need young faces in finance to convert those challenges into opportunities.


    Comment by simon jacques — October 24, 2015 @ 8:20 pm

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